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Asset/Liability Portfolio Risk & CECL Stress Testing

Capital stress testing: The Fed’s scenarios can help smaller financial institutions

Zach Englert
March 14, 2023
Read Time: 0 min

The stress test scenarios for big banks are useful for smaller institutions' own tests 

Smaller banks can leverage DFAST scenarios in their own capital stress tests for planning and risk management.

You might also like this podcast, "Stressed out: How to sleep easier at night about your capital and risk levels."

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Takeaway 1

The 2023 stress test scenarios released by banking regulators for DFAST institutions can help smaller financial institutions analyze the potential impact of adverse outcomes.

Takeaway 2

The severely adverse scenario from regulators presents a very severe global recession combined with severe stress in commercial and residential real estate markets and the corporate debt market.

Takeaway 3

Regulators will be focused on capital levels in the current environment. Capital levels can change quickly, reinforcing the benefits of stress tests.

Capital adequacy

Why financial institutions stress test

The Federal Reserve Board recently released hypothetical scenarios for 2023 capital stress tests on banks subject to Dodd-Frank Act Stress Test (DFAST) requirements. However, community banks can also leverage the DFAST stress test scenarios to benefit their planning, strategy, risk management, and communications with regulators and investors.

Purpose of Fed stress tests

The purpose of the Fed’s stress tests is to assess the ability of large banks to weather economic shocks and ensure they have enough capital to continue operating in a difficult environment.

The economic stress tests evaluate banks by estimating losses, net revenue, and capital levels under hypothetical recession scenarios extending two years into the future. The results are crucial in determining the adequacy of large banks’ capital planning processes. They’re also vital to ensuring the stability of the U.S. financial system. Finally, this capital stress testing using these Fed scenarios helps ensure that large banks can continue to lend to households and businesses even in a severe recession.

The results are crucial in determining the adequacy of large banks’ capital planning processes.

Banks and credit unions can tailor them to their own instances rather than building them from the ground up – editing the regulator-developed scenarios as opposed to creating them from scratch.

Modify Fed scenarios

Smaller institutions can leverage Fed scenarios

However, aside from these large banks, smaller community banks can incorporate DFAST scenarios to help with their own capital stress testing and operations. Banks and credit unions can tailor the scenarios to their own instances rather than building them from the ground up. They can edit the regulator-developed scenarios in stress testing software instead of creating them from scratch for the institution’s financial models.

Below is a look at four ways these financial institutions can use the stress test scenarios to benefit their bank or credit union.

  1. Using the scenarios, banks can evaluate their ability to withstand economic shocks and analyze how various risk factors could impact their loan portfolios.
  2. The scenarios can be used to inform capital planning and strategic decision-making. Banks can use the results of running the stress tests to evaluate their capital adequacy and assess whether they have sufficient capital or need to raise additional capital to meet regulatory requirements.
  3. Banks can use the scenarios to evaluate their business models and identify opportunities to improve efficiency and profitability.
  4. Community banks can use the DFAST stress test scenarios to communicate with regulators and investors. Banks can use the scenarios to demonstrate their ability to withstand adverse economic conditions and provide assurance to regulators and investors that they are well-capitalized and have effective risk management practices in place.

Stay up to date with stress testing best practices.

Overall, while community banks are not required to participate in the stress tests, they can still leverage the scenarios as a tool to assess their own internal risk management practices, inform capital planning and strategic decision-making, and communicate with regulators and investors.

Hypothetical scenarios

What are the 2023 scenarios for stress testing?

It is important to note that the stress test scenarios are not forecasts and should not be interpreted as predictions of future economic conditions.

Baseline scenario

For the baseline scenario the Federal Reserve stress test is based on the consensus projections from the 2023 Blue Chip Financial Forecasts and 2023 Blue Chip Economic Indicators report, but is not a Federal Reserve forecast.

The scenario features an initial slowdown followed by a gradual recovery, with the unemployment rate rising to near 5 percent before declining, real GDP growth declining before gradually increasing, and inflation declining to a trough before remaining steady. Interest rates, equity prices, and real estate prices are also expected to follow a gradual trend in the baseline scenario. The scenario assumes a modest decline in equity market volatility before increasing to a set level for the remainder of the scenario.

Severely adverse scenario

The Fed describes the severely adverse scenario as follows:

“The severely adverse scenario is characterized by a severe global recession accompanied by a period of heightened stress in both residential and commercial real estate markets, as well as in corporate debt markets. The U.S. unemployment rate rises nearly 6½ percentage points from the starting point of the scenario in the fourth quarter of 2022 to its peak of 10 percent in the third quarter of 2024. The sharp decline in economic activity is also accompanied by an increase in market volatility, widening corporate bond spreads, and a collapse in asset prices, including a 38 percent decline in house prices and a 40 percent decline in commercial real estate prices.”

It's important to note, once again, that these are hypothetical scenarios.

Fed stress test scenarios - unemployment rates

Utilizing the above scenarios in their capital planning stress testing, community banks should aim to meet the following goals:

  • Adequate level of capital: The bank should have a sufficient level of capital to withstand potential losses during stress scenarios.
  • Relevant stress scenarios: The stress test should include scenarios that are relevant to the bank's risk profile and market conditions. One option is to look at historical performance and highlight the correlation or perform a regression analysis to determine which indicators have impacted the loan portfolio. Once the institution determines the relationship between its portfolio performance and relevant economic indicators such as unemployment or PCE or GDP, it can then tie those loss rates directly to the current portfolio.
  • Consistent methodology: Conduct tests using a consistent stress testing methodology that accurately reflects the bank's risk exposure.
  • Transparent results: The stress test results should be transparent and easily understood by regulators, investors, and other stakeholders.
  • Action/contingency plans: The bank should have an action plan in place to address any capital shortfalls identified by the stress test program so it will meet regulatory capital requirements and ensure its continued stability.
  • Regular testing: Run stress tests regularly to ensure that the bank's capital position remains robust and resilience.

The DFAST bank stress testing scenarios may technically be meant only for the largest U.S. financial institutions. However, smaller financial institutions can benefit from using the scenarios as a starting point to conduct their own assessments of capital resilience.

Some financial institutions struggle to conduct accurate stress tests. This can happen when data required for the capital stress test is stored in disparate, siloed systems that can be difficult to access and reconcile. It can take hours for institutions that rely on manual, spreadsheet-based processes, which are also error-prone. Another common challenge for financial institutions is relying on scenarios that don’t reflect current market dynamics.

Stress testing consultants or advisors can help on all fronts. They can help develop scenarios or perform the outsourced stress testing. They can also help institutions that have recently adopted the current expected credit loss model (CECL) incorporate the results in their stress testing methodologies, data, and disclosures.

Capital levels can change quickly, and with many institutions facing minimal losses for years, they can be lulled into assuming their capital situation isn’t a risk. Regulators will be focused on capital levels, especially in the current environment, so understanding how to utilize the Fed’s stress testing scenarios and using them contributes to sound risk management.

How can you identify key vulnerabilities in the current environment? Read the whitepaper, "Stress Testing: Managing Capital Levels and Credit Risk."

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About the Author

Zach Englert

Manager, Advisory Services
Zach Englert is a Manager with the Abrigo Advisory Team, helping provide institutions with real-time solutions in the form of applicable credit risk management strategies and regulatory compliance. Zach routinely speaks at conferences and webinars covering current events and the impact on community financial institutions’ portfolios. By working with hundreds

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Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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